Greek Tragedy Part II

My family and I returned to Canada last week from a 3 week vacation in Italy, France and England, staying with friends and seeing family, as well checking out possible schools in England for the children. We were in Europe at the height of the Euro-zone debt crisis, yet it was remarkable how little effect the impending implosion of the peripheral economies such as Greece, Portugal and Ireland seemed to have on French and Italian citizens and visitors. It was hard to discern any concern about the collapse of the Euro on the French Riviera amongst the well dressed and prosperous-looking holidaymakers strolling through the streets of Antibes or Nice. Likewise the elegant and stylish inhabitants of Milan and the tourists flocking around the Duomo and La Scala didn’t appear gripped by angst over the potential return of the lira.

Over the next couple of weeks, I will be examining some of the issues that have emerged as the Euro debt crisis has developed, including the outlook for the Euro and European banks, few comparisons between the cost of living in Europe and North America and some individual company ideas that emerged from our travels. Of course, in Europe, July and August are holiday time, when half of Paris leaves for the month of July and the other half for August, causing horrendous traffic jams (“Bouchant”(kissing), as the Auto-route signs phrase it) on the roads down to the Mediterranean. Germans and Scandinavian tourists descend en masse on beaches in Spain, Italy and Greece, although the latter has not been too popular this year with all of the strikes affecting it, while hard drinking British youths infest Majorca and Minorca and just about anywhere else that is cheap to fly to and has cheap beer and wine. A lack of interest in arcane financial dealings is understandable, and the crisis in Greece and the other peripheral Euro-zone economies such as Portugal and Ireland has been rumbling on for over a year.

However, the realization that holders of Euro-zone debt were becoming increasingly worried about Spain and Italy, as it became apparent that the E110 bn ($150 bn) bailout of Greece last May, let alone the E78 bn for Portugal and the E65 bn for Ireland, had not worked, finally struck home in Brussels. As yields on Spanish 10 year debt rose above 6% and above 5.25% for Italy, the Eurocrats were staring over the edge of a debt precipice. Neither Spain nor Italy could afford to fund their budget deficits at these rates and maintain their existing social and industrial policies, while it finally sank in that Greece Ireland and Portugal were trapped in a a classic 1930s style “paradox of thrift” debt deflation. As Keynes pointed out, what is logical behaviour for individuals and companies, cutting expenditures and practicing austerity, was doomed to failure, as one person’s expense was another person’s revenues. Thus attempting to cut your way to solvency merely saw revenues falling even faster than expenses and the deficit widening, not shrinking, as Greece and Ireland have been demonstrating over the last eighteen months.

With the E109 bn package announced last Thursday, July 21st, 2011, Germany, the heart of the Euro-zone and the banker of the whole Euro project, has accepted the logic of the Euro experiment for the first time. Within a currency union such as the Euro-zone, unless there is a willingness on the part of member states to contribute resources to other member states when they run into financial difficulty, then the only solution for the countries in difficulty is to leave the currency zone and devalue to regain competitiveness. This, in effect, is what the UK did in September 1992, when George Soros and other “speculators” helped drive the pound sterling out of the predecessor to the Euro, the ERM. Sterling was devalued by 30%, making Mr Soros several billion dollars as he became “the man who broke the Bank of England”.

Within a few years, however, the British economy was booming as reduced imports and rising exports contributed to an export led manufacturing boom, reinforced by rising tourism revenues and capital inflows as the UK became a very cheap place to visit and live. In the end, last week’s rescue of Greece and the other PIIGS may yet end up with the weaker countries leaving the Euro, which reverts to being what it originally was; the Deutschmark by another name. Germany’s immediate neighbours in the Benelux countries and France will form part of a currency bloc which is driven by the performance and needs of the German economy, and not weighted down by Mediterranean economies which cannot remain competitive with Germany.

Of course, the rescue package also effectively created a European Monetary Fund in the European Financial Stability Facility (EFSF), whose E440 bn of capital can now be used to buy sovereign bonds in the secondary market and issue “precautionary” loans to countries that face liquidity pressures. It will also offer borrowers longer maturities and lower interest rates than those with which their bonds originally were offered.

This is a default by Greece, soon to be followed by Portugal and Ireland. The private sector, in this case largely French, Spanish and Italian banks, will be forced to accept longer dated bonds with lower interest payments than those they had on their balance sheets. Of the E109 bn, E35 bn will need to be kept in a contingency fund to ensure that the new bonds will be repaid and that lenders will be willing to accept the new bonds, while another E20 bn will be needed to recapitalize Greek banks which hold the old bonds as capital. It is estimated this will be equivalent to a 21% “haircut” or loss, but more realistic estimates indicate that losses will run between 50% and 75%.

in my next posting, I will look at some of the consequences of this decision and what it means for investors in European markets.